As a recovering lawyer, and a serial entrepreneur, I constantly have associates, friends, and family coming to me for advice on formation issues (amongst other things). I think your high level overview leaves out something that always comes as a surprise to these people: the concept of “Piercing the Corporate Veil” of liability protection.

As you know there are certain rules, forms and procedures which must be followed as a liability shielded entity, be it S Corp, LLC, C Corp (or even as a limited partner). To not follow these forms strips the liability protection away from the company and exposes the person to personal liability as if they were a sole proprietor. For some reason, people are always surprised by this. Situations arise where records are not kept, annual meetings are not held, control is exerted, or personal funds are co-mingled with the business. When the company is involved in litigation, the owners find themselves on the hook. Depending upon the jurisdiction, any of a laundry list of things could wind up stripping the protection away.

I said last week that forming a company is the best way to “putting a buffer between you and the business.” But as Shawn and others point out in last week’s comment thread, you can’t just pretend to be a business, you have to be a business.”Being a business” means separating your personal and business records, separating your personal and business bank accounts, treating the business as a real entity, having board meetings, taking board minutes, doing major activities via board resolutions, following “due process.”

If you don’t behave as a real business, you could find yourself in a situation where someone, most commonly someone who is suing your business, can come after you (and your business partners) personally. And then you are going to say “but what about the liability limitation the business provides?” It may not be there for you.

That’s called “piercing the corporate veil”. And you should take that threat seriously. So once you create a company, treat it seriously, follow the rules, and do it right. Once again, if you have a good lawyer, he or she will lay this all out for you and even give you many of the tools to do this stuff right.

From the comments

Having just spent over $400,000 defending our corporate structure (multi-state, multi-unit highly regulated and licensed operating business) against a “piercing” attack from a southern state Department of Revenue and Licensing, I can assure you that following corporate formalities is very, very, very important.

The main benefit of a corporation is the protection afforded its shareholders from the liabilities of the corporation.

To obtain this protection, the corporation must really BE a corporation and must conduct its business AS a corporation.

A corporation must be properly formed, have a charter, bylaws, officers, directors, annual meetings of shareholders, board meetings, minutes and a business plan.

The danger signs are failing to follow and document corporate formalities, undercapitalization (remember a big insurance policy is evidence of capitalization), an alter ego who controls the corporation’s fortunes, the commingling of personal and corporate assets, non-functioning officers/directors and the way the corporation presents itself in the marketplace.

If you are not scared enough also consider that while there has historically been a presumption that corporations do exist for the purposes intended and the burden of proof has been high recent cases have lowered the bar significantly — courts have allowed creditors to go after persons or entities who “control” the enterprise’s fate (that might be a VC) even when not employees, officers or directors and have lowered teh threshold of proof to to a “preponderance of the evidence” rather than “clear and convincing evidence”.

It is a hard cruel world out there, so buckle up your corporation and follow the rules.

You really can’t emphasize strongly enough about getting a good attorney. And not just someone from a big firm, but rather someone who understands the start-up world. Generally their fees are somewhat lower than big firms but also their expertise in doing the things that Fred mentions (like Board activities) to make sure you keep the corporate veil as strong as possible. And god forbid, if you run into cash flow problems, that you make payroll and pay your taxes.

This post was originally written by Fred Wilson on March 1, 2010 here.